Pension Funds Online

Global pensions in 2009

The ultimate challenge for pension plan sponsors across the globe is maintaining the appropriate level of benefits for their workforce without crippling their company in the process.

However, a business’ ability to support and honour an occupational pension plan is becoming increasingly difficult as regulatory, investment and governance pressures grow. Consequently, those working at the coalface of pensions management must make some tough decisions about the future of their plans as they determine the best course of action in a testing economic environment.

The first and perhaps most immediate challenge for employers running defined benefit (DB) pension plans is the volatility in the world’s equity markets, with those schemes heavily reliant on shares feeling particularly battered and bruised. US and UK pension plans are among the biggest investors in the global stock markets and consequently have felt the brunt of plunging returns, although even Europe with a relatively low overall allocation failed to avoid the fallout.

This equity market turbulence has caused pension fund deficits to spiral ever upwards and has meant plan sponsors face a growing demand for additional cash contributions to their plans. The renewed funding calls come just at a time when cash-strapped sponsors can ill afford to commit larger amounts of the business’ funds to their pension plans, leading many to ask how they can make occupational retirement provision more affordable.

The decline of defined benefit

One option for plan sponsors is to simply close the DB plan to new members and offer a defined contribution (DC) scheme in its place. Such action has long been in evidence in the UK and US, and is becoming increasingly prevalent in the rest of the world.

However, where the US and UK have gone a step further and closed some DB plans to future accrual entirely, employment law and labour agreements in other countries, particularly in Europe, can prevent employers from taking this step.

For companies that wish to retain their DB plans but pass some of the burden to the members, cost and/or risk sharing offers an alternative route. Many companies in the UK have increased the share of costs borne by employees in recent years by increasing employee contribution rates.  

In the Netherlands one element of risk sharing is applied by conditional indexation schemes, which provides an option for employers to link pension increases to the scheme’s funding level.  These schemes have proved particularly successful and it has not led to the same level of decline in DB pension provision as seen elsewhere.  However, because risk sharing schemes pass just some of the burden to members, the idea is likely to receive a limited response from employers in countries where DC is already well established.

Investment strategies

The global financial crisis has focused investors’ minds on how they structure their portfolios and brought issues of risk to the fore. Investment strategies are seen as the cause of deficits, but should also be seen as a potential route to resolving them. Plan sponsors are taking a more thorough approach to portfolio management – using better risk management techniques on both the asset and liability sides, for example including a greater use of liability-driven investment and use of swaps to reduce inflation and interest rate risks.

Although the detrimental impact of holding any equities has been acute, this doesn’t seem to have accelerated the trend out of the asset class. Where sponsors have a view that the global economy will recover at some stage, they seem to be willing to ride out the storm until some semblance of order is restored. However, now more than ever before, investors appreciate the risks associated with equities and, as funding and accounting regulations tighten, they are likely to implement a staged reduction in the asset class if markets climb back towards previous levels.

Across Europe, investor confidence in active management has been shaken heavily as investors question managers’ ability to add value in such unprecedented markets. As such, many active mandates, especially in core asset classes, are being reviewed as plan sponsors consider whether the merits of active management outweigh the extra costs.

At the same time, sponsors are looking for alternative sources of return as part of a more diversified portfolio. Consequently all eyes are on asset classes that investors hope may do well on the way out of a recession - such as equities and corporate bonds - as well as a greater interest in structured loans, commodities, and diversified growth funds.

Where sponsors believe markets may recover, or where they might be struggling to fund their DB plan with cash contributions, another approach opening up to plan sponsors is contingent assets. The UK is something of a pioneer in this area and plan sponsors are starting to recognise the increased flexibility this route provides. Contingent assets allow sponsors to call on other forms of collateral to back the pension plan – these might include escrow accounts, parent company guarantees and a wide range of other options. Such options are technically possible in the US with appropriate regulatory approval, although we have yet to see the widespread use of contingent assets in Europe.

Governance

Burgeoning governance responsibilities pose yet another challenge for occupational pension plans and their sponsors. Regulators across the world are paying closer attention to how companies manage their retirement risks, and how retirement funds operate, with funding requirements becoming more stringent.

The UK remains one of the most highly regulated and complex pensions systems, but the pensions landscape globally continues to develop, characterised by innovative solutions that focus on the needs and characteristics of the domestic and insight from what has worked elsewhere. In the Netherlands, for example, the increase in administrative and governance obligations has led some schemes to pass control of their plan to a third-party insurance company or fiduciary manager. There has also been a growth in admissions to industry-wide plans as employers seek to relieve themselves of the cost and complexity of keeping their schemes in house.  However, this can potentially have adverse governance consequences, due to the loss of control and transparency.

For multi-national employers with schemes in numerous countries across the world the governance burden becomes even more immense. More firms are seeking advice on how best to implement a global governance framework including a proactive oversight committee which allows them to understand and manage the risks, thereby protecting the interests of shareholders.

Defined Contribution (DC)

As the popularity of DB wanes and DC rises in its place, employers face a whole new raft of challenges. Many of these are centred on setting appropriate contribution rates and investment strategies which are capable of delivering adequate benefits to members in retirement. In Germany and Switzerland, some companies offer a DC arrangement which promises savers a minimum return. However, many of these plans have failed to hit their targets as a result of the global slowdown, meaning money which could have gone towards members’ future benefits is instead being used to plug holes in their past benefits.

For companies offering more traditional DC schemes there has been a lot of attention focused on default funds, which remain by far the most popular choice for the majority of savers. Many of the existing default funds are based on lifestyle strategies which see members invest in equities until they are within a few years of retirement, at which point they are automatically switched into bonds. The inadequacy of this approach has been highlighted by the recent falls in share prices which locked in significant equity losses for those members approaching retirement and left them with a radically diminished income.

Pension schemes are starting to respond to these failings and there is a recognition that the industry needs to think smarter about default design. Increasingly members are able to lock in gains they have made on equities throughout the course of their investment lifetime, which reduces both risk and volatility in their portfolio. While such approaches may limit potential upside gains, investors are willing to sacrifice some return in favour of greater certainty.

M&A

One clear outcome of the global financial crisis has been the improved opportunity for merger & acquisition activity. However, pension schemes continue to play a significant role and with increasing frequency they are thwarting transactions. Large global companies looking to sell a small subsidiary may find they are forced to retain its pension liabilities if they want to make the sale, and both buyers and sellers in the M&A market need to think about the amount of pensions risk they are willing to retain or take on.

Further, with such a large range of assumptions available to businesses when placing a single or range of values on their pension promises, both sides involved in the deal need to be aware of how figures were reached and seek specialist advice. In particular, the ever increasing divergence between price based on cash funding measures (common in the UK) and price based on accounting measures (common in the US) can lead to radically different negotiating positions.  This is a new challenge for global deals.

Pensions may not be the top priority for every business battling to survive in such difficult conditions, but they continue to command a considerable amount of time and resource. For some firms this commitment has become an unbearable burden and the decision has been taken to step away from a paternal role. For others there remains a genuine desire to see occupational schemes flourish in spite of the testing economic environment and the industry continues to strive to find solutions to the numerous challenges facing today’s plans. However, more work needs to be done to continue to support the remaining DB schemes and to make the world’s DC funds more flexible and relevant for savers.

Shaun Southern FIA                              Colin Haines FIA Dip.IEB

Partner                                                 Partner

Lane Clark & Peacock LLP